Capital Gains Yield

The formula for the capital gains yield is used to calculate the return on a stock based solely on the appreciation of the stock. The formula for capital gains yield does not include dividends paid on the stock, which can be found using the dividend yield. The capital gains yield and dividend yield is combined to calculate the total stock return.

The capital gains yield formula uses the rate of change formula. Calculating the capital gains yield is effectively calculating the rate of change of the stock price. The rate of change can be found by subtracting an ending amount from the original amount then divided by the original amount.

The capital gains yield will equal a company's total stock return if a company does not pay dividends. A company that pays no dividends will have a 0% dividend payout ratio, a 100% retention ratio, and a 0% dividend yield.

Capital Gains Yield for Multiple Periods

It is important to remember that if the yields for multiple periods are known, they can not be simply summed to determine the yield for the entire period. For example, if the monthly yields are known, one can not simply add the yields to determine the annual capital gains yield. The holding period return formula must be used when calculating a yield over multiple periods.

Alternative Capital Gains Yield Formula

The capital gains yield formula can also be stated as the ending price divided by the initial price then minus one. This alternative formula is a rearranging of the capital gains yield formula shown at the top of the page.

The capital gains yield formula can also be stated as

which is another way of stating a change in (Delta) price divided by the original stock price.

Capital Asset Pricing Model (CAPM)

The capital asset pricing model provides a formula that calculates the expected return on a security based on its level of risk. The formula for the capital asset pricing model is the risk free rate plus beta times the difference of the return on the market and the risk free rate.

Risk and the Capital Asset Pricing Model Formula

To understand the capital asset pricing model, there must be an understanding of the risk on an investment. Individual securities carry a risk of depreciation which is a loss of investment to the investor. Some securities have more risk than others and with additional risk, an investor expects to realize a higher return on their investment. For example, assume that an individual has $100 and two acquaintances would like to borrow the $100 and both are offering a 5% return($105) after 1 year. The obvious choice would be to lend to the individual who is more likely to pay, i.e., carries less risk of default. The same concept can be applied to the risk involved with securities.

The risk involved when evaluating a particular stock is accounted for in the capital asset pricing model formula with beta. Specifically regarding the capital asset pricing model formula, beta is the measure of risk involved with investing in a particular stock relative to the risk of the market. The beta of the market would be 1. An individual security with a beta of 1.5 would be as proportionally riskier than the market and inversely, a beta of .5 would have less risk than the market.

Risk Free Rate in the Capital Asset Pricing Model Formula

The risk free rate would be the rate that is expected on an investment that is assumed to have no risk involved. For the US, the US treasury bill rate is generally used as it is short term and the collapse of the treasury bill would theoretically, at minimum, be a large enough disruption to inhibit gauging value, or at worse, be a collapse of the entire monetary system which relies on a fiat currency.

Risk Premium in the Capital Asset Pricing Model Formula

The capital asset pricing model formula can be broken up into two components: the risk free rate and the risk premium of the particular security.

The risk premium is beta times the difference between the market return and a risk free return. In the capital asset pricing model formula, by subtracting the market return from a risk free return, the risk of the overall market can then be determined. By multiplying beta times this risk of the market, the risk of the individual stock can then be determined. As previously stated, beta is the risk of an individual security relative to the market. A beta of 2 would be twice as risky as the market. In practice, risk is synonymous with volatility. A stock with a beta larger than the market beta of 1 will generally see a greater increase than the market when the market is up and see a greater decrease than the market when the market is down.

Alternative Capital Asset Pricing Model Formula

When regression analysis is applied to the capital asset pricing model based on prior returns, the formula will be shown as above. Alpha is considered to be the risk free rate and epsilon is considered to be the error in the regression.

Book Value per Share

The book value per share formula is used to calculate the per share value of a company based on its equity available to shareholders. The term "book value" is a company's assets minus its liabilities and is sometimes referred to as stockholder's equity, owner's equity, shareholder's equity, or simply equity.

Stockholder's equity, or owner's equity, can be found on the balance sheet for the company.

Concept of Book Value per Share

Book value per share is just one of the methods for comparison in valuing of a company. Enterprise value, or firm value, market value, market capitalization, and other methods may be used in different circumstances or compared to one another for contrast. For example, enterprise value would look at the market value of the company's equity plus its debt, whereas book value per share only looks at the equity on the balance sheet. Conceptually, book value per share is similar to net worth, meaning it is assets minus debt, and may be looked at as though what would occur if operations were to cease. One must consider that the balance sheet may not reflect with certain accuracy, what would actually occur if a company did sell all of their assets.

Use of Book Value per Share

The book value per share may be used by some investors to determine the equity in a company relative to the market value of the company, which is the price of its stock. For example, a company that is currently trading for $20 but has a book value of $10 is selling at twice its equity. This example is referred to as price to book value (P/B), in which book value per share is used in the denominator. In contrast to book value, the market price reflects the future growth potential of the company.

Book value per share is also used in the return on equity formula, or ROE formula, when calculating on a per share basis. ROE is net income divided by stockholder's equity. Net income on a per share basis is referred to as EPS, or earnings per share. As shown at the top of this page, book value per share is expressing stockholder's equity on a per share basis.

Bond Equivalent Yield

The bond equivalent yield formula is used to determine the annual yield on a discount, or zero coupon, bond. When making investment decisions, comparing the yield or returns on the investment choices in relative terms is important. The return on a 6 month bond would obviously be less than on a 12 month bond, ceteris paribus. Likewise, the percentage of return would be less yet equally profitable when considering the length of investment. The bond equivalent yield formula can be used to compare these two investments with different maturities in relative terms.

Breakdown of the Bond Equivalent Yield Formula

The first portion of the bond equivalent formula shows the return on investment as a percentage. The face value is the amount paid at maturity and the price is the amount originally paid. By subtracting the price from the face value, the monetary return can be found. In simple terms, if one spends $75 to be repaid with $80 in 6 months, that individual has made $5. By dividing the return by the original price, we can find the percentage return on the investment. Using the prior example of $5 that was made on the original $75 purchase, the individual has made 6.667% in those 6 months.

The second portion of the bond equivalent formula annualizes the first portion of the formula. A simple example would be a 6 month bond with a 5% yield during the 6 months. The 5% yield would be determined with the first portion of the formula and multiplying by approximately 2 would give the annual yield. The second portion of the formula for this example would be approximately 2 and not exactly 2 due to there being 365 days in a year which does not exactly fit into a half year.

Bid-Ask Spread

The bid ask spread formula is the difference between the asking price and bid price of a particular investment. The bid ask spread may be used for various investments and is primarily used in investments that sell on an exchange.

Use of the Bid Ask Spread

The bid ask spread may be used to determine the liquidity of a particular investment. A higher trade volume, or higher liquidity, will generally lead to a lower bid-ask spread. One analogy could be comparing the difference in asking price and the offer price of a home or piece of art(not sold at an auction). These assets may take longer to sale and there may be less individuals looking to buy the individual's particular asset. On the other hand, stocks, commodity futures, currency exchanges and futures are often considered to be more liquid as many buyers and sellers trade on the market every day that the exchange is open.

The bid ask spread may also connote the costs involved with buying a particular investment when an intermediary holds and purchases the investment. For example, suppose that a specialist on an exchange will offer to sell and are also willing to purchase the same security. The gap between the price they're willing to sell at and the amount they will purchase the security for would be considered a profit for them and a theoretical cost for the other party.

Example of the Bid Ask Spread

Suppose that a particular stock is offered at $37.80 and the bid price is $37.75 is the bid price. The bid ask spread would be the .05 difference between the two investments. In order for a transaction to take place, an offer matching the bid price or a bid matching the offer price would need to match, which will in turn leave another gap to be in place.

Real Rate of Return

The real rate of return formula is the sum of one plus the nominal rate divided by the sum of one plus the inflation rate which then is subtracted by one. The formula for the real rate of return can be used to determine the effective return on an investment after adjusting for inflation.

The nominal rate is the stated rate or normal return that is not adjusted for inflation.

The rate of inflation is calculated based on the changes in price indices which are the price on a group of goods. One of the most commonly used price indices is the consumer price index(CPI). Although the consumer price index is widely used, a company or investor may want to consider using another price index or even their own group of goods that relates more to their business when calculating the real rate of return.

For quick calculation, an individual may choose to approximate the real rate of return by using the simple formula of nominal rate - inflation rate.

Example of Real Rate of Return Formula

An example of the real rate of return formula would be an individual who wants to determine how much goods they can buy at the end of one year after leaving their money in a money market account that earns interest.

For this example of the real rate of return formula, we must assume that the individual wants to purchase the exact same goods and same proportion of goods that the consumer price index uses considering that it is used often to measure inflation.

For this example of the real rate of return formula, the money market yield is 5%, inflation is 3%, and the starting balance is $1000. Using the real rate of return formula, this example would show

which would return a real rate of 1.942%. With a $1000 starting balance, the individual could purchase $1,019.42 of goods based on today's cost. This example of the real rate of return formula can be checked by multiplying the $1019.42 by (1.03), the inflation rate plus one, which results in a $1050 balance which would be the normal return on a 5% yield.

Rate of Inflation

The rate of inflation formula measures the percentage change in purchasing power of a particular currency. As the cost of prices increase, the purchasing power of the currency decreases.

The rate of inflation formula shown uses the Consumer Price Index which is released by the Bureau of Labor Statistics in the US. However, other similar indices may be used at times. If another index is used, "CPI" in the rate of inflation formula is replaced by the alternate index.

The subscript "x" refers to the initial consumer price index for the period being calculated, or time x. And such, subscript "x+1" would be the ending consumer price index for the period calculated, or time x+1.

Use of Rate of Inflation Formula

The formula for the rate of inflation is primarily used by economists. On the financial side, the rate of inflation may be used by corporations to compare expenses, revenues, and profit across multiple years.

The rate of inflation formula shown is not to be confused with the purchasing power of goods relative to income.
An example, albeit an extreme example, would be an individual who recently discovers that their income will increase to $1,000,000 from $20,000 per year--a 5,000% increase. The individual, unable to hold back excitement, decides to go shopping only to discover that a loaf of bread suddenly increased to $300 from $3--a 10,000% increase. The same result occurs as the individual purchases more products. Soon the individual realizes that they are worse off than prior to the income change. The rate of inflation formula measures only inflation, the 10,000% price increase in the example, and does not consider income, the 5,000% income increase in the example, or standard of living.

Annualizing the Rate of Inflation Formula

As with annualizing any monthly rate, the monthly rate of inflation can not be annualized by simply multiplying it by 12, as this does not consider compounding. The same concept can be applied to adding each monthly percentage change in the consumer price index as an attempt to find the annual percentage change in the consumer price index. The proper way to calculate the annual rate of inflation is to use the year's initial and ending CPI in the formula.

Return on Equity (ROE)

The formula for return on equity, sometimes abbreviated as ROE, is a company's net income divided by its average stockholder's equity. The numerator of the return on equity formula, net income, can be found on a company's income statement.

Average Stockholder's Equity in the ROE Formula

The denominator of the return on equity formula, average stockholder's equity, can be found on a company's balance sheet. Stockholder's equity is a company's assets minus its liabilities. When calculating the return on equity, the stockholder's equity should be averaged based on the time being evaluated. For example, if an investor is calculating the return on equity for 2012, then the beginning and ending stockholder's equity should be used.

Stockholder's equity is also referred to as net assets.

ROE Formula vs. Return on Assets Formula

The difference between return on equity and return on assets can be found in the denominators of each formula. For return on assets, the denominator is average total assets and for the return on equity formula, the denominator is average stockholder's equity. Both of these variables can be found on a company's balance sheet.

Assets shown on a balance sheet is stockholder's equity plus liabilities. Therefore, the return on equity formula is the same as return on assets except that it does not include liabilities.

Use of ROE Formula

The return on equity can be used internally by a company or can be used by an investor to evaluate how well the company is turning a profit relative to its stockholder's equity.

Alternative ROE Formula

The return on equity can also be calculated by multiplying Profit Margin x Asset Turnover x Equity Multiplier. See Return on Equity DuPont for further explanation.

Return on Assets

The return on assets formula, sometimes abbreviated as ROA, is a company's net income divided by its average of total assets. The return on assets formula looks at the ability of a company to utilize its assets to gain a net profit.

Net income in the numerator of the return on assets formula can be found on a company's income statement. Net income is the amount earned by a company after subtracting out the expenses incurred, including depreciation and taxes.

Average total assets in the denominator of the return on assets formula is found on a company's balance sheet. The average of total assets should be used based on the period being evaluated. For example, if an investor is calculating a company's 2015 return on assets, the beginning and ending total assets for that year should be averaged.

ROA Formula vs. Asset Turnover Ratio

The distinct difference between return on assets and asset turnover is that the return on assets considers net income and asset turnover considers revenues. By using net income instead of revenues, the return on assets formula factors in a company's expenses.

The asset turnover ratio can be used to calculate return on assets with the following formula

Net Profit Margin is revenues divided by net income and the asset turnover ratio is net income divided average total assets. By multiplying these two together, revenues is cancelled out leaving the formula for return on assets shown on top of the page.

Use of ROA Formula

The return on assets formula can be used by an investor or by a company internally to evaluate if the company is turning a profit relative to their assets. It is important for an investor to consider that a company's return on assets can vary depending on which industry the company does business in. A particular company may provide a product that requires additional assets to manufacture the product relative to another industry.

Retention Ratio

The retention ratio, sometimes referred to as the plowback ratio, is the amount of retained earnings relative to earnings. Earnings can be referred to as net income and is found on the income statement. Retained earnings is shown in the numerator of the formula as net income minus dividends.

The retention ratio formula is an important component to other financial formulas, particularly growth formulas. The retention ratio formula looks at how much is kept by the company, as opposed to being paid out to common stock shareholders. Whatever amount the company retains, will be reinvested for growth in the company. A company's retained earnings could be considered an opportunity cost of paying dividends for stockholders to invest elsewhere.

A company that retains a large portion of its net income, will anticipate having high growth or opportunities to expand its business. High retention ratios are generally seen in growing companies more than established blue chip companies, but many other factors, such as the type of industry and stability of the overall economy, are considered as well.

Alternative Formula

The alternate formula to the retention ratio is 1 minus the payout ratio.

The payout ratio is the amount of dividends the company pays out divided by the net income. This formula can be rearranged to show that the retention ratio plus payout ratio equals 1, or essentially 100%. That is to say that the amount paid out in dividends plus the amount kept by the company comprises all of net income.

Receivables Turnover Ratio

The receivables turnover ratio formula , sometimes referred to as accounts receivable turnover, is sales divided by the average of accounts receivables.

Sales revenue is the amount a company earns in sales or services from its primary operations. Sales revenue can be found on a company's income statement under sales revenue or operating revenue.

Average accounts receivable in the denominator of the formula is the average of a company's accounts receivable from its prior period to the current period. For example, if a company has $200,000 in accounts receivables at the end of one period and had $150,000 of accounts receivables ending in the prior period, the average would be $175,000. Accounts receivables can be found on a company's balance sheet.

Use of the Receivables Turnover Ratio

The receivables turnover ratio is used to calculate how well a company is managing their receivables. The lower the amount of uncollected monies from its operations, the higher this ratio will be. In contrast, if a company has more of its revenues awaiting receipt, the lower the ratio will be.

Although the formula for the receivables turnover ratio is fairly simple, applying the ratio in a particular situation to determine efficiency can become more complex. A company needs to collect revenues in order to cover expenses and/or reinvest. A lack of collecting sooner is potentially a loss of future earnings from reinvesting. However, customers may look to competitors if the collection is overbearing.

Example of the Receivables Turnover Ratio

Suppose that the income statement from a company shows operating revenues of $1 million. The same company has accounts receivables of $80,000 this period and $90,000 the prior period. The average accounts receivables is $85,000 which can be divided into the $1 million for a ratio of 11.76.

Quick Ratio

The Quick Ratio is used for determining a company's ability to cover its short term debt with assets that can readily be transferred into cash, or quick assets. The Current Liabilities portion references liabilities that are payable within one year.

The Quick Ratio provides an idea of how solvent a company is without requiring sales to cover the short debt, which differentiates it from the current ratio. The quick ratio can also be written as

Current Assets are assets that can be realized within one year. Inventory, which is included in the current ratio, is excluded in the quick ratio.

Payback Period

The payback period formula is used to determine the length of time it will take to recoup the initial amount invested on a project or investment. The payback period formula is used for quick calculations and is generally not considered an end-all for evaluating whether to invest in a particular situation.

The result of the payback period formula will match how often the cash flows are received. An example would be an initial outflow of $5,000 with $1,000 cash inflows per month. This would result in a 5 month payback period. If the cash inflows were paid annually, then the result would be 5 years.

At times, the cash flows will not be equal to one another. If $10,000 is the initial investment and the cash flows are $1,000 at year one, $6,000 at year two, $3,000 at year three, and $5,000 at year four, the payback period would be three years as the first three years are equal to the initial outflow.

Use of Payback Period Formula

There are a few drawbacks to the payback period formula that may warrant one to consider using another method of determining whether to invest.

One issue is that the payback period formula does not look at the value of all returns. Suppose a situation where there are two choices to choose from where investment X has a payback period of 1 year and investment Y has a payback period of 2 years. However, investment X will only return the initial investment whereas investment Y will eventually pay double the initial investment. Given the additional information not provided by the payback period formula, one may consider investment Y to be preferable. The formula for the net present value method may be used to close this information gap in order to properly evaluate the best choice.

However, it is worth mentioning that although the net present value method may be preferable to determine long term profitability, the payback period formula helps with cash flow analysis for short term budgeting. Suppose a situation where investment X has a net present value of 10% more than its initial investment and investment Y has a net present value of triple its initial investment. At first glance, investment Y may seem the reasonable choice, but suppose that the payback period for investment X is 1 year and investment Y is 10 years. Investment Y could cause problems if the investment is needed sooner. An analogy of this would be like banks where maintaining cash flows of their investments(loans) is vital to their business.

Another issue with the formula for period payback is that it does not factor in the time value of money. The time value of money concept, as it applies to the payback period formula, proposes that each future cash flow is worth less when compared to today's value. The discounted payback period formula may be used instead to consider the time value of money, however the discounted payback period formula takes away the benefit of making quick calculations.

Net Working Capital

The formula for net working capital (NWC), sometimes referred to as simply working capital, is used to determine the availability of a company's liquid assets by subtracting its current liabilities.

Current Assets are the assets that are available within 12 months. Current Liabilities are the liabilities that are due within 12 months.

Use of Net Working Capital Formula

Net working capital is used in various other financial formulas that deal with cash flows. Examples of these formulas include the free cash flow to equity formula and free cash flow to firm formula.

In the formula for free cash flow to equity, the change in net working capital is subtracted. An increase in net working capital is considered a negative cash flow and not available for equity. In other words, an increasing requirement for capital for short term operations in the company is not available to equity.

The variables of the net working capital formula are the same as those used in the current ratio. The current ratio formula instead divides current assets by current liabilities. And such, a company with a current ratio of greater than 1 will have positive net working capital. These formulas, along with others, are referred to as liquidity ratios as they are measures of a company's ability to meet its short term obligations.

Net Working Capital

The formula for net working capital (NWC), sometimes referred to as simply working capital, is used to determine the availability of a company's liquid assets by subtracting its current liabilities.

Current Assets are the assets that are available within 12 months. Current Liabilities are the liabilities that are due within 12 months.

Use of Net Working Capital Formula

Net working capital is used in various other financial formulas that deal with cash flows. Examples of these formulas include the free cash flow to equity formula and free cash flow to firm formula.

In the formula for free cash flow to equity, the change in net working capital is subtracted. An increase in net working capital is considered a negative cash flow and not available for equity. In other words, an increasing requirement for capital for short term operations in the company is not available to equity.

The variables of the net working capital formula are the same as those used in the current ratio. The current ratio formula instead divides current assets by current liabilities. And such, a company with a current ratio of greater than 1 will have positive net working capital. These formulas, along with others, are referred to as liquidity ratios as they are measures of a company's ability to meet its short term obligations.

Net Profit Margin

The net profit margin formula looks at how much of a company's revenues are kept as net income. The net profit margin is generally expressed as a percentage. Both net income and revenues can be found on a company's income statement.

Use of Net Profit Margin Formula

One mistake a company or investor may make is to equate company growth, or an increase in sales, with a proportionate increase in profits. This does not take into account the costs associated with the growth of a company. As a company grows, its expenses will at times grow along with it, perhaps at a greater rate than sales. As the expense of a company rises, the net profit margin may shrink. Even attempts to compensate the added expenses with an increase in the sales price of the product, may result in a decrease in the quantity of sales as consumers may not be as willing to purchase the product at the higher price. If this were to happen, total revenues could decrease despite the increase of price per product.

In some situations, the opposite may happen as the cost of production could decrease as production increases.

Although these issues are primarily related to other financial and economic concepts, it is important for a company to apply this formula to monitor its net profit margin as the company changes.

Example of Net Profit Margin Formula

A company's income statement shows a net income of $1 million and operating revenues of $25 million. By applying the formula, $1 million divided by $25 million would result in a net profit margin of 4%. Although the formula is simplistic, applying the concept is important in that 4% of sales will result in after tax profit.

Net Present Value

Net Present Value(NPV) is a formula used to determine the present value of an investment by the discounted sum of all cash flows received from the project. The formula for the discounted sum of all cash flows can be rewritten as

When a company or investor takes on a project or investment, it is important to calculate an estimate of how profitable the project or investment will be. In the formula, the -C₀ is the initial investment, which is a negative cash flow showing that money is going out as opposed to coming in. Considering that the money going out is subtracted from the discounted sum of cash flows coming in, the net present value would need to be positive in order to be considered a valuable investment.

Example of Net Present Value

To provide an example of Net Present Value, consider company Shoes For You's who is determining whether they should invest in a new project. Shoes for You's will expect to invest $500,000 for the development of their new product. The company estimates that the first year cash flow will be $200,000, the second year cash flow will be $300,000, and the third year cash flow to be $200,000. The expected return of 10% is used as the discount rate.

The following table provides each year's cash flow and the present value of each cash flow.

Year             Cash Flow                 Present Value
 0                 -$500,000                 -$500,000
 1                  $200,000                   $181,818.18
 2                  $300,000                   $247,933.88
 3                  $200,000                   $150,262.96

Net Present Value = $80,015.02

The net present value of this example can be shown in the formula

When solving for the NPV of the formula, this new project would be estimated to be a valuable venture.

Inventory Turnover Ratio

The formula for the inventory turnover ratio measures how well a company is turning their inventory into sales. The costs associated with retaining excess inventory and not producing sales can be burdensome. If the inventory turnover ratio is too low, a company may look at their inventory to appropriate cost cutting.

The denominator of the formula, inventory, is an average inventory for the period being analyzed. If monthly sales are used in the numerator of the formula, then the monthly average of inventory should be used.

Mental Notes for Inventory Turnover Ratio Formula

One key note with the inventory turnover ratio is that the formula does not take into consideration fixed expenses. The formula provided does not consider any type of debt, but the alternative formula in the following section may be used to compare the cost of goods sold, which provides more information on a company's ability to meet its inventory costs by turning over inventory. However, the cost of goods sold method looks at only certain variable expenses and does not consider all expenses or fixed expenses.

An example of the affect this could have is a company whose sales have reduced and, in turn, decided to reduce their inventory. It is possible that the company may have maintained the same inventory turnover ratio, but they may not be able to maintain all of their debt based on sales.

Given this, it is important to note that the formula for the inventory turnover ratio is only an inventory ratio and not a liquidity ratio, such as the current ratio. It serves an individual purpose even when cost of goods sold is used.

Alternative Formula

An alternative formula used for the inventory turnover ratio is:

As stated in the previous section, the cost of goods method looks at a company's ability to meet the direct costs associated with selling their product. This should be not confused with the overall costs associated with running the business. The benefit to using this method is to eliminate gross profit from consideration.

A hypothetical example of this benefit would be two companies who operate exactly the same, yet one company has higher gross profit(sales minus Cost of Goods Sold). Both companies sale 10,000 units, have the exact same cost of goods sold for the 10,000 units, yet company A sales their product at a higher price than company B. Using sales as the numerator, both companies may appear to be equal if their inventory turnover ratios are the same. But, company A would have a lower inventory turnover ratio if costs of goods sold was used.

Interest Coverage Ratio

The formula for the interest coverage ratio is used to measure a company's earnings relative to the amount of interest that it pays. The interest coverage ratio is considered to be a financial leverage ratio in that it analyzes one aspect of a company's financial viability regarding its debt.

One consideration of the interest coverage ratio is that earnings can fluctuate more than interest expense. It is important to look at prior trends of a particular company as the interest coverage ratio does not consider future projected earnings. In addition, as with any financial formula, no one ratio or formula should be used in isolation.

Interest Coverage Ratio Formula Variables

The variable EBIT in the interest coverage ratio formula stands for earnings before interest and taxes. EBIT is also referred to as operating income, which is revenues minus operating expenses. Interest expense refers to the amount of interest the company pays on its debt.

Both EBIT and interest expense can be found on a company's income statement.

Use of the Interest Coverage Ratio Formula

Internally, a company may use this formula to review its ability to meet its obligations.

An investor may consider a company's trend in borrowing, revenues, expenses, and assets. The formula shown for the interest coverage ratio would bring one piece of the puzzle by evaluating a company's debt expense and revenue. An investor in bonds or a lender may pay more attention to a company's financial leverage to determine the likelihood of meeting its debt obligations.

Free Cash Flow to Firm (FCFF)

The free cash flow to firm formula is capital expenditures and change in working capital subtracted from the product of earnings before interest and taxes (EBIT) and one minus the tax rate(1-t).

The free cash flow to firm formula is used to calculate the amount available to debt and equity holders.

Variables of the FCFF Formula

Earnings before interest and taxes, EBIT, is, as it suggests, the earnings from a company's operations before adjusting for interest expense and taxes. EBIT can be found on the company's income statement or calculated from the cash flow statement. The free cash flow to firm formula does adjust for taxes by multiplying EBIT by one minus the tax rate.

Capital expenditures (Capex) is the capital used to fund operations in the long run. Capital expenditures can be found on a company's cash flow statement.

Working capital is capital used to fund operations in the short run. Working capital is current assets minus current liabilities. As opposed to longer term capital expenditures, working capital connotes expenses due within one year or less. The change in working capital can be calculated using a company's balance sheet.

FCFF Formula vs. FCFE Formula

Free cash flow to firm differs from free cash flow to equity in that it calculates the amount available to both debt and equity holders, as opposed to simply equity holders. One part of how this difference is shown in the free cash flow to firm formula is by instead of using net income, EBIT adjusted for taxes is used. This allows interest expenses to be included as they are paid to debt holders.

Another difference between FCFF and FCFE is that the free cash flow to firm formula does not subtract out change in debt. As with other differences listed above, this difference is applied in order to include the amount available to debt.

Use of the FCFF Formula

As stated in the prior section, the free cash flow to firm formula is used to determine how much debt and equity holders have available. Apart from this general use of the free cash flow to firm, it may also used in valuation models for a company's stock using the FCFFapproach to discounting future cash flows. In this approach, FCFF is used in place of dividends.